There are government rules that control what's allowed with forfeited FSA funds:
- The funds can’t be returned to individual employees based on the amount forfeited because that would violate the “use it or lose it” rule.
- You can’t donate the funds to charity or take a tax deduction from them.
- Likewise, if an employee terminates when their reimbursements for the year are greater than their contributions to that point, you may not withhold additional funds from their final paycheck, and you cannot send them a bill for the difference. Additional payroll contributions beyond the final paycheck can only be made if the employee elects to continue their plan through FSA COBRA.
However, you do have a few options available. Whichever option you choose, you will need to include that information in your plan document.
Option 1: Reimburse administrative expenses
The most common option is to reimburse your own medical FSA administrative expenses.
The expenses must be “reasonable” and payment of the expense must not be a prohibited transaction according to the Employee Retirement Income Security Act of 1974 (ERISA). The qualifications for a reasonable administration expense are:
- The payment must not be prohibited by the plan document (e.g., if the plan document requires the employer alone to pay administrative expenses, then forfeitures can’t be used for those expenses
- The expense must relate to the health FSA administration and cannot be an initial expense of establishing the plan (e.g. a “settlor” expense) or an expense related to another plan. The funds cannot be used to pay for DCAP administration expenses
- The expense must be incurred because of the needs of the plan
If you choose this option, you must keep detailed records of the expenses, including the amount and date of the transaction, as well as what the expenses were used for.
Unless your plan document specifies timing, the forfeitures can be applied to the expenses of any plan year.
Option 2: Reduce FSA fees for the following plan year
You can choose to effectively reduce the FSA fees for participants in the year following the plan year.
For example, if the forfeitures total $1,000 you have 100 employees, you can choose to offer $10 off next year’s FSA coverage. An employee could elect to deduct a $1,000 for the next year’s FSA, but you would only deduct $990 from their payroll.
If you choose this option, the forfeitures must be applied during the year the forfeitures are discovered.
In other words, if employees forfeit some of their money in the original plan year (Year 1), and those forfeitures are discovered immediately afterward (Year 2) they must be applied to FSA participants at that time. You cannot hold on to the funds and apply them for open enrollment for the next year.
Option 3: Add to your employees’ FSA coverage
This is similar to reducing fees, but instead of decreasing how much employees are deducting from payroll, in this option you are adding to their coverage limit.
For instance, if you have $5,000 in forfeitures and 1,000 employees with FSAs, you may add $5 to each employee’s FSA.
You can also use a weighted method in distributing the forfeitures to employees.
If you have four employees and two elected FSAs for $1,000 and the other two for $2,000, and there were $400 in forfeitures from the previous year, the company may give $67 to the two employees with $1,000 FSAs and $133 to the two with $2,000 FSAs.
Employees who elect to deduct the FSA maximum and still receive the additional FSA coverage, even if it pushes them over the annual limit, as long as that permission is included in your plan document.
The same timing rules apply to this option as the option to reduce FSA fees. The forfeitures must be applied during the year the forfeitures are discovered instead of holding them to apply toward the next year.
Option 4: Return the funds to employees in cash
Cash refunds are allowed but rarely used because it can be tricky to track down employees who left the company. Also, payroll taxes must be applied to cash refunds. If you have more questions about the cash refund process, you may contact the Department of Labor at 1-866-487-2365.
Like the other options, cash returns must be distributed in a reasonable and uniform manner. They cannot be given to people to match the amount they forfeited. They can use the weighted method based on how much the employees elected to contribute, or by giving the same amount to all participants.
There are no time limits for the refunds to be made to the employees.